GRAT, short for Grantor Retained Annuity Trust, is a type of irrevocable trust that alleviates the tax cost of passing assets to your beneficiaries. When the inevitable comes and you pass, your family may have to pay millions in estate taxes if your assets exceed $11.2 million. A GRAT is there to minimize the taxes by transferring your wealth and avoiding gift and estate taxes.
How does a GRAT work?
A grantor transfers property into an irrevocable trust in exchange for the right to receive fixed payments. A grantor should transfer income producing assets, like real estate or businesses. Essentially the grantor is making a gift of company stock to the GRAT, which is an irrevocable trust that cannot be modified. The grantor in turn receives a steady stream of income from the trust. The grantor would receive an annuity from the trust for a certain number of years. The grantor may choose the numbers of years as long as it is a minimum of two years, as a GRAT cannot be any less.
The annuity that the grantor receives is a fixed dollar amount that does not fluctuate. The annuity is usually received annually but can be made more frequently if the grantor would like. During the term you designate in your GRAT, you control your assets and receive annuity payments. At the end of the specified time, any remaining value in the trust is passed on to a beneficiary of the trust as a gift. The beneficiaries are usually the grantor’s children or grandchild, but they do not have to be. Once the GRAT term ends, the remaining property in the trust passes to the beneficiaries and will not be included in your estate.
How is a GRAT beneficial?
GRAT is beneficial because when transferring your assets to the trust you will not have to pay a gift tax if it is structured correctly. The moment you transfer your assets to the GRAT it will cause a gift tax event; however, you will not have to pay taxes on the value of the assets you transferred into the GRAT. Instead, the gift is reduced by the value of the grantor’s retained annuity interest, which should equal the fair market value of the assets if done correctly. Thus, the difference between the fair market value of the assets and the annuity interest should equal zero and no gift tax will be applied when transferring your assets.
Additionally, at the end of the GRAT term, the remaining value in the trust is passed to your beneficiaries, and not included in your estate. Therefore, your estate assets are reduced, allowing your beneficiaries to pay less estate taxes once you pass.
There is a catch when it comes to a GRAT. If the grantor dies before the GRAT term is over, the entire value can be included in the estate, increasing the amount of estate tax your beneficiaries will have to pay. However, this may be avoided by creating a shorter GRAT term so that the grantor can survive the GRAT.